January 18, 2010

How To Be A Conservative Investor

If based on the first definition, investors already know what qualifies as a conservative investment, one needs to know which characteristics define a conservative investment, which is where the second definition comes into play. There are three broad categories which investors can use to identify a conservative investment.

The Safety FactorClearly, any conservative investment should be able to weather market storms better than the rest. In order to do this, certain characteristics must stand out. First, a business should have a low cost of production.

Being a low-cost producer has the principal advantage that, when a bad year hits the industry, the chance of still churning out a profit or reporting a smaller net loss is available. Second, a business should have a strong research and marketing department. A company that cannot compete by staying abreast of market changes and trends is doomed in the long run. Finally, management should possess financial skill. In doing so, they will be well versed in things like per unit cost of production, maximizing return on investment capital, and other essential elements of business success.

The People FactorThis is a rather self-explanatory qualification for a conservative investment. But take notice that excellent people can only be beneficial after a business has demonstrated the signs of quality above. Take note of Warren Buffett’s advice:

“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

A small company can succeed on the heels of one or two exceptionally talented people. But as a business grows, people throughout the organization must be counted if the company is to succeed and remain a conservative investment.

Characteristics of the BusinessThis third quality requires a little more work for investors but is well worth the effort. Here, the goal for investors is to determine what advantages (or disadvantages) may prevent the business from growing and earning more profits, despite satisfying the first two conditions. One important thing to consider is the competitive landscape of the business; the existence of many competitors or the relative ease with which new competition can enter can affect the best of companies. The potential for excessive regulation could also be a game changer.

Even when a company satisfies the obvious conditions of being a conservative investment, you should always remember to consider this third condition. The following examples will illustrate this concept further. (To learn more, see Economic Moats: A Successful Company’s Best Defense.)

Those Who Fail and Those Who PassGreat examples of those businesses that pass the test include names like Coca-Cola (NYSE:KO), Wal-Mart (NYSE:WMT) and Johnson & Johnson (NYSE:JNJ). These companies have demonstrated time and time again the strengths of their franchises. Even more importantly, these companies will likely continue to have very favorable future prospects. Coke essentially competes with Pepsi and Dr. Pepper and no one else. More so, it’s unlikely that entrepreneurs are sitting in garages thinking about creating the next great soft drink company.

Because Wal-Mart exists and succeeds, that should raise a red flag for most other retailers, save for Target. Remember Circuit City, which used to be number two to Best Buy in electronic retailing? It’s now bankrupt, in no small part due to Wal-Mart. Of course, once a passing company has been identified, the stock price only matters in determining the value gained.

Conclusion: A Collective ApproachInvesting conservatively is not about simply identifying large, well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment. And as you can see from the names above, being a conservative investor can lead to some of the most dependable and respectable returns in the market. (For more, check out Achieving Optimal Asset Allocation.)